The State of the Markets:
My quote system confirms that stocks finished higher on the week and that the S&P 500 gained ground all five days last week. And with the venerable index closing Friday at the second highest level ever on a daily basis (and the highest ever on a weekly basis), one can't be blamed for being enthused about the action.
However, I am struggling to get overly excited here and I wouldn't call the recent rally robust, as the intraday action seems to be driven more by the hopes that the trade war with China will come to an end soon than a rush to buy stocks. For example, take a look at a chart of the small caps last week - can you say sideways? And then there is the chart of the banks - ugh.
Yes, there is some good stuff happening in the market. But I guess my primary point on this fine Monday morning is that there is also some bad stuff to be found, as well as some downright ugly stuff. So, in an attempt to remain objective, I'm going to take a quick run through the good, the bad, and the ugly here.
The Economy/Earnings: Unless you've been sleeping in a cave, you can probably spit out the bull case pretty quickly. First and foremost, as the saying goes, "it's the economy..." Then there is the fact that earnings are at record highs - and expected to continue to grow.
In reality, these two issues alone are probably enough for the bulls to maintain possession of the ball and likely the reason that the major indices are within spitting distance of all-time highs - despite all the worries out there.
When one digs into the economic data, it is frankly difficult not to be upbeat. And this is definitely the case with small business owners. As Exhibit A, take a look at the chart of the NFIB's Small Business Optimism Index below.
Jobs: While economics can be more art than science, the idea is that when business owners feel good about what is happening, they think about growth, and expanding, and, of course, hiring. On that note, check out the NFIB's Hiring Plans Index below.
Consumers are Happy Campers: Now mix in the recent reports on the state of the consumer. For example, we learned last week that Retail Sales have improved by 6.5% over the latest 12-month period, which represents the strongest level since December 2011. Digging deeper, we find that Discretionary Retail Sales advanced 5.5%, which was the best in three and a half years and the "core" reading was the best in seven years.
In addition, the Reuters/University of Michigan Consumer Sentiment Index rebounded 4.6 points in last week's September survey to a reading of 100.8, which was the second highest reading since January 2004.
All in, these stats suggest underlying consumer strength, which, is a positive for the economic outlook because, of course, the consumer accounts for more than two-thirds of GDP.
Inflation: Another positive can be found on the inflation front. First, let's remember that the Fed has been working hard to get inflation UP to their purported target of 2%. So, as the charts of both CPI and Core CPI illustrate, it appears that this mission has been accomplished. Check.
However, it is also positive that the trend of CPI appears to be turning down. This would seem to suggest that we don't need to worry about inflation overheating - at least for now.
No Recession in Sight: And finally, I follow several "Odds of Recession" models on a weekly basis. The bottom line here is that while the odds of a recession in the U.S. are rising (a wee bit), the models suggest that the actual chances of a recession in the near-term remain quite small. And since the worst bear markets in stocks tend to coincide with recessions, this too is a positive.
Since I wrote a "Negative Nancy" piece entitled, What If Something Bad Actually Happens last week, I don't think I need to do a deep dive reviewing the bear case here.
The Trade War: Yet it is important to remember that there is what can be construed as a wall of worry out there. First, we've got the trade war, which continues to provide headlines for the algos to react to. Frankly, I remain amazed that Trump's profession to favor more tariffs continues to be news. How many times can the S&P drop 10 points in a couple minutes on the same headline?
About Those Happy Campers: Unfortunately, there is a "bad" associated with the good consumer confidence. Data from Ned Davis Research shows that good news on the consumer confidence front has actually been bad news for the stock market. Since 1967, the DJIA has gained ground at an average annualized rate of just 2.5% when the reading of the Conference Board's Consumer Confidence index has been above 110. The current reading is over 130, which is the highest level seen since the end of 2000.
De-FANGed: Next up, it looks like the so-called "FANGs" need an "AA" meeting as the charts of Facebook (FB), Netflix (NFLX), and Google's parent, Alphabet (GOOG) could cause one to drink heavily (however, a couple "A's" - as in Amazon (AMZN) and Apple (AAPL) continue to work well). The key concern here is that when "crowded" trades end, the rotation can be disruptive.
QT: Another concern that I didn't spend time on last week is a little something called "QT" (quantitative tightening). Yes, the Fed needs to return monetary policy back to "normal." This means that yes, this time it is indeed different in terms of the monetary models waving red flags.
However, if the Fed either misplays or overplays their hand, the worry is the result could be economic weakness.
Peak GrowthThen there is the "peak" argument. As in "peak earnings" and/or "peak economic growth."
Remember, the stock market is a discounting mechanism for future expectations. So, the simplest explanation for the "peak" worries is that if the rate of growth in the economy and/or earnings slows too much, so too will the multiple investors are willing to pay for stocks.
Late Innings: Finally, the words "late innings" - as in, "the current bull run is in the late innings" - were used a fair amount last week. First, there was hedge fund manager extraordinaire, David Tepper, saying that it was late in the game and he isn't very exposed to stocks right now. If you will recall, the once reclusive Tepper has been known to move markets, so it will be interesting to see if folks take his current caution about stocks to heart.
Then there are the folks at Ned Davis Research, who as you may know, tend to get the big-picture right the vast majority of the time. They too have been using the words "late innings" to describe the current "state of the market" recently.
Although stocks often climb a wall of worry, I'm going to suggest that the market doesn't ignore truly ugly conditions forever. And while the bulls are clearly still large and in charge here, I think it is important to remember that there are a few downright ugly issues to be aware of.
Valuations: First up is the valuations issue. I probably don't need to spend a lot of time here as most everybody knows that valuations are elevated by just about every traditional metric. However, the Price/Sales Ratio makes the point very clear. The chart below goes back to 1955.
The first peak in the P/S was in 2000. The second is now. 'Nuff said.
One of the valuation metrics that has been getting attention lately is the capitalization of the stock market as a percentage of GDP. The current reading for this ratio is 47.66 which is actually off the recent high of over 50. This reading was the highest since 2000 and the only other time the reading was at this level was in the 1930's.
History (and the computers at Ned Davis Research Group) shows that the stock market has not performed well after the percentage of stock market capitalization to GDP has been above 32.5. For example, one year later, the S&P 500 Total Return index sports an average gain of just 0.7%. Three years later, the market averaged a gain of only 1.23%. And five years later, the average gain has been 0.5%. Ugly indeed.
But then again, as the saying goes, "Valuations don't matter until they do. And then they matter a lot." So...
$1 Trillion Deficits Next up is the debt/deficit situation. We talked about debt last week. It will suffice to say, "Debt kills."And in this category, we need to look at the budget deficit of the U.S. I'll let an excerpt from this week's Barron's article on the subject summarize the situation:
According to Barron's, the only other time that debt-to-GDP approached this level was during World War II. Oh, and in 2003, this ratio was around 30%.
The External Factors Board Finally, let me draw your attention to my External Factors Indicator Board, which is published each week. But I've copied it below to make the point easier to see.
This week, I described the "state" of this board as "just plain ugly." As such, I thought it was appropriate to call you attention to it. The key here is that of the five models I use to highlight the market's "external" factors, only one is on a buy signal - this at a time when stocks are near all-time highs. Can you say, divergence?
My takeaway from this week's macro review is this. First, the bulls have possession of the ball. Second, the trend is up, and investors need to remember that the trend is their friend. Third, there are "issues" to be aware of because when the tide does turn, and the bears find a "reason to be," those negatives WILL matter.
So, as a risk manager, I believe it is appropriate to stay seated on the bull train here. However, you should know where the exits are and have a plan to manage risk when/if the bears take control of the game.
Have a great week!
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I like to start each week with a review of the state of my favorite big-picture market models, which are designed to help me determine which team is in control of the primary cycle.
The Bottom Line:
Once I've reviewed the big picture, I then turn to the "state of the trend." These indicators are designed to give us a feel for the overall health of the current short- and intermediate-term trend models.
The Bottom Line:
Next up are the momentum indicators, which are designed to tell us whether there is any "oomph" behind the current trend.
The Bottom Line:
We also focus each week on the "early warning" board, which is designed to indicate when traders might start to "go the other way" -- for a trade.
The Bottom Line:
Now let's move on to the market's "external factors" - the indicators designed to tell us the state of the big-picture market drivers including monetary conditions, the economy, inflation, and valuations.
The Bottom Line:
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Today's Portfolio Review:
2018 YTD Performance Update:
Daily Decision Portfolio: +9.51%
S&P 500: +8.65%
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The Front Range Trading Team
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